STAT Formulas

Notes for STAT-402
For CS and IT students mainly

Spring Semester 2020
Sets, Operations on sets, Venn Diagram

Rules of Counting: Factorial, Permutation, Combination
Probability, Laws of Probability, Conditional Probability
Random Variable, Mathematical Expectation
Probability Distributions (Discrete and Continuous)
Decision Analysis, Decision Criterion Utility, Expected Utility
1
Chapter Goals
After completing this chapter, one should be able to:
 Explain basic probability concepts and definitions
 Use a Venn diagram or tree diagram to illustrate simple
probabilities
 Apply common rules of probability
 Compute conditional probabilities
 Determine whether events are statistically independent
 Use Bayes’ Theorem for conditional probabilities
 Compute mathematical expectation
 Have knowledge of discrete & continuous probability
distributions: (Binomial & Poisson) & (Gaussian)
 Understand basic concepts of Decision Analysis
2
Section on
Rules of Counting, Sets, Probability
After completing this section, one should be able to:

 Explain basic probability concepts and definitions
 Use a Venn diagram or tree diagram to illustrate simple
probabilities
 Apply common rules of probability
 Compute conditional probabilities
 Determine whether events are statistically independent
 Use Bayes’ Theorem for conditional probabilities
3
Fundamental Counting Principle
Fundamental Counting Principle can be used

determine the number of possible outcomes
when there are two or more characteristics .
Fundamental Counting Principle states that

if an event has m possible outcomes and
another independent event has n possible
outcomes, then there are m* n possible
outcomes for the two events together.
4
Fundamental Counting Principle
Lets start with a simple example.
A student is to roll a die and flip a coin.
How many possible outcomes will there be?
1H 2H 3H 4H 5H 6H
1T 2T 3T 4T 5T 6T 6*2 = 12 outcomes
12 outcomes
For a college interview, Ali/Alia has to

choose what to wear from the following: 4
slacks, 3 shirts, 2 shoes and 5 ties. How
many possible outfits does he/she have to
choose from? 4*3*2*5 = 120 outfits
5
Permutations: ORDER MATTERS!
A Permutation is an arrangement of items in a

particular order.
To find the number of Permutations of n items, we can
use the Fundamental Counting Principle or factorial
notation.
The number of ways to arrange the____
letters ABC:
____ ____
Number of choices for first blank? 3 ____ ____
Number of choices for second blank? 3 2 ___
Number of choices for third blank? 3 2 1
3*2*1 = 6 3! = 3*2*1 = 6
ABC ACB BAC BCA CAB CBA 6
Permutations
To find the number of Permutations of n items chosen r at a time,
you can use the formula
n!
n p r  ( n  r )! where 0  r  n.
5! 5!
Practice: 5 p3  
( 5  3 )! 2!
 5 * 4 * 3  60
A combination lock will open when the right

choice of three numbers (from 1 to 30, inclusive)
is selected. How many different lock
combinations are possible assuming no number is
repeated?
30 ! 30!
30 p3    30 * 29 * 28  24360
( 30  3 )! 27!
7
Combinations: ORDER DOES NOT MATTER!
A Combination is an arrangement of items in

which order does not matter.
Since the order does not matter in combinations, there are
fewer combinations than permutations.
The combinations are a "subset" of the permutations.
n!
To find the number of C  where 0  r  n .
n r r!(n  r )!
Combinations of nn
items chosen rr at a 5! 5!
5 C3   
time, you can use the 3! (5  3)! 3!2!
formula
5 * 4 * 3 * 2 * 1 5 * 4 20
   10
3 * 2 * 1* 2 * 1 2 * 1 2
8
Combinations
Practice: A basketball team consists of two centers, five forwards,

and four guards. In how many ways can the coach select a
starting line up of one center, two forwards, and two
guards?
Center: Forwards: Guards:
2! 5! 5 * 4 4! 4 * 3
2 C1   2 5 2
C    10 4 C2   6
1 !1 ! 2!3! 2 * 1 2!2! 2 * 1
2 C1 * 5 C 2 * 4 C 2
Thus, the number of ways to select the

starting line up is 2*10*6 = 120.
9
Important Terms
 Random Experiment – a process leading to an
uncertain outcome
 Basic Outcome – a possible outcome of a random
experiment
 Sample Space – the collection of all possible
outcomes of a random experiment
 Event – any subset of basic outcomes from the
sample space
10
Important Terms
(continued)
 Intersection of Events – If A
S
and B are two events in a
sample space S, then the A
intersection, A Ç B, is the set of B
A
B
all outcomes in S that belong to
both A and B
 Union of Events – If A
S
and B are two events in
a sample space S, then
the union, A U B, is the A B
set of all outcomes in S
that belong to either
The entire shaded area represents A U B
A or B 11
Important Terms (continued)
 A and B are Mutually Exclusive S

Events if they have no basic
outcomes in common
A B
 i.e., the set A Ç B is empty
 Events E1, E2, … Ek are Collectively Exhaustive

events if E1 U E2 U . . . U Ek = S
 i.e., the events completely cover the sample space
 The Complement of an event A is
S
the set of all basic outcomes in the A
sample space that do not belong to A
A. The complement is denoted A
12
Examples
Let the Sample Space be the collection of all
possible outcomes of rolling one die:
S = {1, 2, 3, 4, 5, 6}
Let A be the event “Number rolled is even”

Let B be the event “Number rolled is at least 4”
Then
A = {2, 4, 6} and B = {4, 5, 6}
13
Examples (continued)
S = {1, 2, 3, 4, 5, 6} A = {2, 4, 6} B = {4, 5, 6}
Complements: A  {1, 3, 5} B  {1, 2, 3}
Intersections: A  B  {4, 6} A  B  {5}
Unions: A  B  {2, 4, 5, 6}
A  A  {1, 2, 3, 4, 5, 6}  S
 Mutually exclusive:
 A and B are not mutually exclusive
 The outcomes 4 and 6 are common to both
 Collectively exhaustive:
 A and B are not collectively exhaustive
 A U B does not contain 1 or 3 14
Probability
 Probability – the chance that an
uncertain event will occur (always
between 0 and 1) 1 Certain
 Probability Postulates
1. If A is any event in the sample space S, then
0  P(A)  1
.5
2. Let A be an event in S, and let Oi denote the
basic outcomes. Then P(A) 

P(O )
A
i
(the notation means that the summation is over all

the basic outcomes in A)
3. Probability of sample space is 1 P(S)  1 0 Impossible
15
Assessing Probability
Three approaches to assess probability of an uncertain
event
1. classical probability
NA number of outcomes that satisfy the event
probability of event A  
N total number of outcomes in the sample space
 Assumes all outcomes in the sample space are equally likely to occur
2. relative frequency probability
nA number of events in the population that satisfy event A
probabilit y of event A  
n total number of events in the population
 the limit of the proportion of times that an event A occurs in a large

number of trials, n
3. subjective probability
an individual opinion or belief about the probability of occurrence
16
Probability Rules
 The Complement rule: P(A)  1 P(A) i.e., P(A)  P(A)  1
 The Addition rule:

 The probability of the union of two events is
P(A or B)  P(A  B)  P(A)  P(B)  P(A  B)
 The Multiplication rule (When events are independent):

 The probability of the intersection of two events is
P(A and B)  P(A  B)  P(A) * P(B)
17
A Probability Table
Probabilities and joint probabilities for two events A

and B are summarized in this table:
B B
A P(A  B) P(A  B ) P(A)
A P(A  B) P(A  B ) P(A)
P(B) P( B ) P(S)  1.0
18
Addition Rule Example
Consider a standard deck of 52 cards, with four suits:
©§¨ª
Let event A = card is an Ace. Let event B = card is from a red suit
P(Red U Ace) = P(Red) + P(Ace) - P(Red Ç Ace)
= 26/52 + 4/52 - 2/52 = 28/52

Don’t count
the two red
Color aces twice!
Type Red Black Total
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52 19
Conditional Probability
 A conditional probability is the probability of one
event, given that another event has occurred:
P(A  B) The conditional

P(A | B)  probability of A given
P(B) that B has occurred
P(A  B) The conditional

P(B | A)  probability of B given
P(A) that A has occurred
20
Conditional Probability Example
 Of the cars on a used car lot, 70% have air

conditioning (AC) and 40% have a CD player
(CD). 20% of the cars have both.
 What is the probability that a car has a CD

player, given that it has AC ?
i.e., we want to find P(CD | AC)
21
(continued)
 Of the cars on a used car lot, 70% have air conditioning
(AC) and 40% have a CD player (CD).
20% of the cars have both.
CD No CD Total
AC .2 .5 .7
No AC .2 .1 .3
Total .4 .6 1.0
P(CD  AC) .2
P(CD | AC)    .2857
P(AC) .7
22
(continued)
 Given AC, we only consider the top row (70% of the cars). Of these,
20% have a CD player. 20% of 70% is 28.57%.
CD No CD Total
AC .2 .5 .7
No AC .2 .1 .3
Total .4 .6 1.0
P(CD  AC) .2
P(CD | AC)    .2857
P(AC) .7
23
Multiplication Rule & Its Example
 Multiplication rule for two events A and B:
P(A  B)  P(A | B) P(B)
 also P(A  B)  P(B | A) P(A)
P(Red Ç Ace) = P(Red| Ace)P(Ace)
 2  4  2
    
 4  52  52
number of cards that are red and ace 2
 
total number of cards 52
Color
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52 24
Statistical Independence
 Two events are statistically independent
if and only if:
P(A  B)  P(A) P(B)
 Events A and B are independent when the probability of one
event is not affected by the other event
 If A and B are independent, then
P(A | B)  P(A) if P(B)>0
P(B | A)  P(B) if P(A)>0
25
Statistical Independence Example (continued)
 Of the cars on a used car lot, 70% have air conditioning
(AC) and 40% have a CD player (CD). 20% of the cars
have both.
 Are the events AC and CD statistically independent?
CD No CD Total
AC .2 .5 .7
No AC .2 .1 .3
Total .4 .6 1.0
P(AC Ç CD) = 0.2
P(AC) = 0.7
P(AC)P(CD) = (0.7)(0.4) = 0.28
P(CD) = 0.4
P(AC Ç CD) = 0.2 ¹ P(AC)P(CD) = 0.28

So the two events are not statistically independent 26
Marginal Probability Example
P(Ace)
2 2 4
 P(Ace  Red)  P(Ace  Black)   
52 52 52
Color
Ace 2 2 4
Non-Ace 24 24 48
Total 26 26 52
27
Using a Tree Diagram
(Not included for the Final Exam)
.2
.7 P(AC Ç CD) = .2
Given AC or
no AC:
P(AC Ç CD) = .5
.5
.7
All
Cars
.2
.3 P(AC Ç CD) = .2
.1 P(AC Ç CD) = .1
.3 28
Summary of Probability Section
 Defined basic probability concepts

 Sample spaces and events, intersection and union of events,
mutually exclusive and collectively exhaustive events,
complements
 Examined basic probability rules
 Complement rule, addition rule, multiplication rule
 Defined conditional, joint, and marginal probabilities
 Defined statistical independence
29
Section on
Random Variable and Probability Distributions
After completing this section, one should be able to:

 Interpret the mean and standard deviation for a
discrete random variable
 Use the binomial probability distribution to find
probabilities
 Describe when to apply the binomial distribution
 Use Poisson discrete probability distributions to find

probabilities
30
Introduction to
Probability Distributions
 Random Variable
 Represents a possible numerical value from
a random experiment
Random
Variables
Discrete Continuous
Random Variable Random Variable
31
Discrete Random Variables
 Can only take on a countable number of values
Examples:
 Roll a die twice

Let X be the number of times 4 comes up
(then X could be 0, 1, or 2 times)
 Toss a coin 5 times.

Let X be the number of heads
(then X = 0, 1, 2, 3, 4, or 5)
32
Discrete Probability Distribution
Experiment: Toss 2 Coins. Let X = # heads.
Show P(x) , i.e., P(X = x) , for all values of x:
4 possible outcomes
Probability Distribution
T T x Value Probability
0 1/4 = .25
T H 1 2/4 = .50
2 1/4 = .25
H T
Probability
.50
H H .25
0 1 2 x 33
Probability Distribution
Required Properties
 P(x)  0 for any value of x
 The individual probabilities sum to 1;
 P(x)  1
x
(The notation indicates summation over all possible x values)
34
Expected Value
 Expected Value (or mean) of a discrete
distribution (Weighted Average)
 E(x)   xP(x)
x
x P(x)
 Example: Toss 2 coins, 0 .25
x = # of heads, 1 .50
compute expected value of x: 2 .25
E(x) = (0 x .25) + (1 x .50) + (2 x .25)

= 1.0
35
Variance and Standard Deviation
 Variance of a discrete random variable X
s 2  E(X  ) 2   (x  ) 2 P(x)
x
2
 
s 2  E(X 2 ) - E(X)    x 2 P(x)    xP(x) 
2
x  x 
 Standard Deviation of a discrete random variable X
 2
  x
(x  ) 2 P(x)
 Example: Toss 2 coins, X = # heads,

compute standard deviation (recall E(x) = 1)
 (0  1)2 (.25)  (1  1)2 (.50)  (2  1)2 (.25)  .50  .707
Possible number of heads

= 0, 1, or 2 36
Probability Distributions
Probability
Distributions
Discrete Continuous
Probability Probability
Distributions Distributions
Binomial Uniform
Hypergeometric Gaussian or Normal
Poisson Exponential
37
Discrete Probability Distribution
Binomial Probability Distribution
 A fixed number of observations, n
 e.g., 15 tosses of a coin; ten light bulbs taken from a warehouse
 Two mutually exclusive and collectively exhaustive
categories
 e.g., head or tail in each toss of a coin; defective or not defective
light bulb
 Generally called “success” and “failure”
 Probability of success is P , probability of failure is 1 – P
 Constant probability for each observation
 e.g., Probability of getting a tail is the same each time we toss
the coin
 Observations are independent
 The outcome of one observation does not affect the outcome of
the other
38
Possible Binomial Distribution Settings
 A manufacturing plant labels items as either

defective or acceptable
 A firm bidding for contracts will either get a contract
or not
 A marketing research firm receives survey
responses of “yes I will buy” or “no I will not”
 New job applicants either accept the offer or reject
it
39
Binomial Distribution Formula
n! X nX
P(x)  P (1- P)
x ! (n  x )!
P(x) = probability of x successes in n trials,
with probability of success P on each trial
Example: Flip a coin four
times, let x = # heads:
x = number of ‘successes’ in sample,
n=4
(x = 0, 1, 2, ..., n)
P = 0.5
n = sample size (number of trials
or observations) 1 - P = (1 - 0.5) = 0.5
P = probability of “success” x = 0, 1, 2, 3, 4
1- P = probability of “failure”
40
Example:
Calculating a Binomial Probability
What is the probability of one success in five
observations if the probability of success is 0.1?
x = 1, n = 5, and P = 0.1
n!
P(x  1)  P X (1 P)n X
x! (n  x)!
5!
 (0.1)1(1 0.1)51
1! (5  1)!
 (5)(0.1)(0.9) 4
 .32805
41
Binomial Distribution
 The shape of the binomial distribution depends on the
values of P and n
Mean P(x) n = 5 P = 0.1
.6
 Here, n = 5 and P = 0.1 .4
.2
0 x
0 1 2 3 4 5
.6
P(x) n = 5 P = 0.5
 Here, n = 5 and P = 0.5
.4
.2
0 x
0 1 2 3 4 5
42
Binomial Di tribution: Mean & Variance
 Mean  E(x)  nP
 Variance s  nP(1- P)
2
s  nP(1- P)
 Standard Deviation
Example
 nP  (5)(0.1)  0.5
Mean P(x) n = 5 P = 0.1
.6
.4
s  nP(1- P)  (5)(0.1)(1  0.1) .2
 0.6708 0 x
0 1 2 3 4 5
 nP  (5)(0.5)  2.5 P(x) n = 5 P = 0.5

.6
.4
s  nP(1- P)  (5)(0.5)(1  0.5) .2
 1.118 0 x
0 1 2 3 4 5
43
U ing PHStat (http ://wp .aw.com/ph tat/)
 Select PHStat / Probability & Prob. Di tribution / Binomial…
44
U ing PHStat
(continued)
 Enter de ired value in dialog box
Here: n = 10
p = .35
Output for x = 0
to x = 10 will be
generated by PHStat
Optional check boxe

for additional output
45
PHStat Output
P(x = 3 | n = 10, P = .35) = .2522
P(x > 5 | n = 10, P = .35) = .0949

46
Di crete Probability Di tribution
The Poi on Di tribution
 Apply the Poi on Di tribution when:

 You wi h to count the number of time an event occur
in a given continuou interval
 The probability that an event occur in one ubinterval i
very mall and i the ame for all ubinterval
 The number of event that occur in one ubinterval i
independent of the number of event that occur in the
other ubinterval
 There can be no more than one occurrence in each
ubinterval
 The average number of event per unit i  (lambda)
47
Poi on Di tribution Characteri tic
 x where:
e
P(x)  x = number of ucce e per unit
x!  = expected number of ucce e per unit
e = ba e of the natural logarithm y tem (2.71828...)
Mean

 E(x) 
 Variance and Standard Deviation
s  E[( X   ) ] 
2 2
s
where  = expected number of ucce e per unit 48
Graph of Poi on Probabilitie
0.70
Graphically: 0.60
 = .50 0.50
= P(x) 0.40
X 0.50
0.30
0 0.6065
0.20
1 0.3033
2 0.0758 0.10
3 0.0126 0.00
0 1 2 3 4 5 6 7
4 0.0016
5 0.0002 x
6 0.0000
P(X = 2) = .0758
7 0.0000
49
Poi on Di tribution Shape
 The hape of the Poi on Di tribution

depend on the parameter  :
0.70
 = 0.50 0.25
 = 3.00
0.60
0.20
0.50
0.15
0.40
P(x)
P(x)
0.30 0.10
0.20
0.05
0.10
0.00 0.00
0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 8 9 10 11 12
x x
50
Joint Probability Function
 A joint probability function i u ed to expre the
probability that X take the pecific value x and
imultaneou ly Y take the value y, a a function of x
and y
P(x, y)  P(X  x  Y  y)
 The marginal probabilitie are
P(x)   P(x, y) P(y)   P(x, y)

y x
51
Conditional Probability Function
 The conditional probability function of the random
variable Y expre e the probability that Y take the
value y when the value x i pecified for X.
P(x, y)
P(y | x) 
P(x)
 Similarly, the conditional probability function of X, given

Y=y i :
P(x, y)
P(x | y) 
P(y)
52
Independence
 The jointly distributed random variables X and Y are
said to be independent if and only if their joint probability
function is the product of their marginal probability
functions:
P(x, y)  P(x)P(y)
for all possible pairs of values x and y
 A set of k random variables are independent if and only

if
P(x1, x 2 ,, x k )  P(x1 )P(x 2 )P(x k )
53
Covariance
 Let X and Y be discrete random variables with means
X and Y
 The expected value of (X - X)(Y - Y) is called the

covariance between X and Y
 For discrete random variables
Cov(X, Y)  E[(X  X )(Y  Y )]    (x  x )(y  y )P(x, y)
x y
 An equivalent expression is
Cov(X, Y)  E(XY)  x y   xyP(x, y)  x y
x y
54
Covariance and Independence
 The covariance measures the strength of the

linear relationship between two variables
 If two random variables are statistically

independent, the covariance between them
is 0
 The converse (opposite) is not necessarily true
55
Correlation
 The correlation between X and Y is:
Cov(X, Y)
 Corr(X, Y) 
X Y
 = 0  no linear relationship between X and Y

 > 0  positive linear relationship between X and Y
 when X is high (low) then Y is likely to be high (low)
 = +1  perfect positive linear dependency
 < 0  negative linear relationship between X and Y
 when X is high (low) then Y is likely to be low (high)
 = -1  perfect negative linear dependency
56
Portfolio Analysis
 Let random variable X be the price for stock A
 Let random variable Y be the price for stock B
 The market value, W, for the portfolio is given by the
linear function
W  aX  bY
(a is the number of shares of stock A,
b is the number of shares of stock B)
57
Portfolio Analysis
(Not included for the Final Exam) (continued)
 The mean value for W is
W  E[W]  E[aX  bY]

a X b Y
 The variance for W is

2
W  a2 2
X  b2 2
Y  2abCov(X, Y)
or using the correlation formula
2
W  a2 2
X  b2 2
Y  2abCorr(X, Y) X Y
58
Example: Investment Returns
Return per $1,000 for two types of investments
Investment
P(xiyi) Economic condition Passive Fund X Aggressive Fund Y
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350
E(x) = x = (-25)(.2) +(50)(.5) + (100)(.3) = 50
E(y) = y = (-200)(.2) +(60)(.5) + (350)(.3) = 95

59
Computing the Standard Deviation for
Investment Returns
Investment
0.2 Recession - $ 25 - $200
0.5 Stable Economy + 50 + 60
0.3 Expanding Economy + 100 + 350
X  (-25  50)2 (0.2)  (50  50)2 (0.5)  (100  50)2 (0.3)

 43.30
y  (-200  95)2 (0.2)  (60  95)2 (0.5)  (350  95)2 (0.3)

 193.71
60
Covariance for Investment Returns
Investment
.2 Recession - $ 25 - $200
.5 Stable Economy + 50 + 60
.3 Expanding Economy + 100 + 350
Cov(X, Y)  (-25  50)(-200  95)(.2)  (50  50)(60  95)(.5)

 (100  50)(350  95)(.3)
 8250
61
Portfolio Example
Investment X: x = 50 x = 43.30
Investment Y: y = 95 y = 193.21
xy = 8250
Suppose 40% of the portfolio (P) is in Investment X and

60% is in Investment Y:
E(P)  .4 (50 )  (.6) (95 )  77
P  (.4)2 (43.30) 2  (.6)2 (193.21)2  2(.4)(.6)(8250)
 133.04
The portfolio return and portfolio variability are between the values
for investments X and Y considered individually
62
Interpreting the Results for Investment Returns
 The aggressive fund has a higher expected

return, but much more risk
y = 95 > x = 50
but
y = 193.21 > x = 43.30
 The Covariance of 8250 indicates that the two

investments are positively related and will vary
in the same direction
63
Continuous Probability Distributions
 There are many types of continuous probability

distributions
Bell Shaped Constant Exponential

Probability Probability Probability
Distribution Distribution Distribution
64
The Normal Distribution
 Bell Shaped
 Symmetrical
 Mean, Median & Mode are Equal f(X)
 Occurs often in business
 Most commonly, it occurs because
of random errors
 Location is determined by the X
mean,
 Spread is determined by the
standard deviation, Mean
 The random variable has an infinite
theoretical range:
= Median
 +  to   = Mode
65
The Normal Distribution
Density Function
(Not included in the final exam)
 The formula for the normal probability density function is

2
1  (X  ) 
1  
2  

f(X)  e
2p
Where e = the mathematical constant a roximated by 2.71828
p = the mathematical constant a roximated by 3.14159
= the o ulation mean
= the o ulation standard deviation
X = any value of the continuous variable
66
Many Normal Distributions
By varying the parameters and , we obtain

different normal distributions
67
Translation to the Standardized
Normal Distribution
 Any normal distribution (with any mean and
standard deviation combination) can be
transformed into the standardized normal
distribution (Z)
 Need to transform X units into Z units
 The standardized normal distribution (Z) has a
mean of 0 and a standard deviation of 1
 Translate from X to the standardized normal (the
“Z” distribution) by subtracting the mean of X and
dividing by its standard deviation: X
The Z distribution always has mean = 0 and standard
Z
deviation = 1
68
The Standardized Normal
Probability Density Function
(Not included for the final exam)
 The formula for the standardized normal
probability density function is
1 (1/2)Z 2
f(Z)  e
2
Where e = the mathematical constant approximated by 2.71828

= the mathematical constant approximated by 3.14159
Z = any value of the standardized normal distribution
69
The Standardized Normal Distribution
 Also known as the “Z” distribution

 Mean is 0
 Standard Deviation is 1
f(Z)
1
Z
0
Values above the mean have positive Z-values,
values below the mean have negative Z-values
70
Example
 If X is distributed normally with mean of 100

and standard deviation of 50, the Z value for
X = 200 is
X 200  100
Z   2.0
50
 This says that X = 200 is two standard
deviations (2 increments of 50 units) above
the mean of 100.
71
Comparing X and Z units
100 200 X ( = 100, = 50)
0 2.0 Z ( = 0, = 1)
Note that the shape of the distribution is the same,

only the scale has changed. We can express the
problem in original units (X) or in standardized
units (Z)
72
Probabilities
For a discrete random variable, we can talk

about the possibility of a single occurrence,
two occurrences, etc.
In contrast, for a continuous random
variable, we can only talk about the
probability of a range of values.
73
Finding Normal Probabilities
Probability is measured by the area

under the curve
f(X)
P (a £ X £ b)
= P (a < X < b)
(Note that the
probability of any
individual value is zero)
a b X
74
Probability as Area Under the Curve
The total area under the curve is 1.0, and the curve is
symmetric, so half is above the mean, half is below
f(X) P(   X  )  0.5
P(  X   )  0.5
0.5 0.5
X
P(  X   )  1.0
75
General Procedure for
Finding Normal Probabilities
To find P(a < X < b) when X is

distributed normally:
 Draw the normal curve for the problem in

terms of X
 Translate X-values to Z-values
 Use the Standardized Normal Table
76
Empirical Rules
What can we say about the distribution of values

around the mean? For any normal distribution:
f(X)
± 1s enclo e about
68.26% of X’
s s
-1s +1s X
68.26%
77
The Empirical Rule
(continued)
 ± 2s cover about 95% of X’

 ± 3s cover about 99.7% of X’
2s 2s 3s 3s
x x
95.44% 99.73%
78
Section Summary
 Defined discrete random variables and

probability distributions
 Discussed the Binomial distribution
 Reviewed the Poisson distribution
 Defined covariance and the correlation between
two random variables
 Examined application to portfolio investment
79
Section on
Decision making/ Decision Analysis
80
Learning Objectives
In this section, one will learn:
 Steps for decision analysis
 To use payoff tables and decision trees to

evaluate alternative courses of action
 To use several criteria to select an alternative
course of action
 To use Bayes’ theorem to revise probabilities in
light of sample information

 About the concept of utility
81
Five Steps in Decision Making
1. Clearly define the problem
2. List all possible alternatives
3. Identify all possible outcomes for each
alternative
4. Identify the payoff for each alternative &
outcome combination
5. Use a decision modeling technique to choose
an alternative
82
Decision Analysis
Types of Decision modeling Environments
Type 1: Decision making under certainty
Type 2: Decision making under uncertainty
Type 3: Decision making under risk
 Certainty
 Decision Maker knows with certainty what the state of
nature will be - only one possible state of nature
 Ignorance
 Decision Maker knows all possible states of nature, but
does not know probability of occurrence
 Risk
 Decision Maker knows all possible states of nature, and
can assign probability of occurrence for each state 83
Some Risks
 Weather changes  Community opposition
 Different productivity  Infighting & acrimonious
 (Sub)contractors are relationships
 Unreliable  Unrealistically low bid
 Lack capacity to do work  Late-stage design
 Lack availability to do work changes
 Unscrupulous  Unexpected subsurface
 Financially unstable conditions
 Late materials delivery  Soil type
 Lawsuits  Groundwater
 Labor difficulties  Unexpected Obstacles
 Unexpected  Settlement of adjacent
manufacturing costs structures
 Failure to find sufficient  High lifecycle costs
tenants  Permitting problems
 … 84
Decision Making Under Uncertainty
 The consequence of every alternative is known
 Usually there is only one outcome for each
alternative
 This seldom occurs in reality
 Probabilities of the possible outcomes are not
known
 Decision making methods:
1. Maximax
2. Maximin
3. Criterion of realism
4. Equally likely
5. Minimax regret 85
Decision Making Under Certainty
Decision Variable
Units to build 150
Parameter Estimates
Cost to build (/unit) $ 6,000
Revenue (/unit) $ 14,000
Demand (units) 250
Consequence Variables
Total Revenue $ 2,100,000
Total Cost $ 900,000
Performance Measure
Net Revenue $ 1,200,000
86
Decision Making Under Ignorance – Payoff Table
(Not included in the final exam )
Construction Payoff Table
State of Nature
Alternative Demand
Actions Low (50 units) Medium (100 units) High (150 units)
Build 50 400,000 400,000 400,000
Build 100 100,000 800,000 800,000
Build 150 (200,000) 500,000 1,200,000
87
Maximax:
The Optimistic Point of View
 Select the “best of the best” strategy

 Evaluates each decision by the maximum possible
return associated with that decision (Note: if cost data
is used, the minimum return is “best”)
 The decision that yields the maximum of these
maximum returns (maximax) is then selected
 For “risk takers”
 Doesn’t consider the “down side” risk
 Ignores the possible losses from the selected
alternative
88
Maximin:
The Pessimistic Point of View
 Select the “best of the worst” strategy

 Evaluates each decision by the minimum possible
return associated with the decision
 The decision that yields the maximum value of the
minimum returns (maximin) is selected
 For “risk averse” decision makers
 A “protect” strategy
 Worst case scenario the focus
89
Decision making under risk
Available Techniques
 Decision modeling
 Decision making under uncertainty
 Tool: Decision tree
 Strategic thinking and problem solving:
 Dynamic modeling (end of course)
 Fault trees
90
Introduction to Decision Trees
 We will use decision trees both for

 Illustrating decision making with uncertainty
 Quantitative reasoning
 Represent
 Flow of time
 Decisions
 Uncertainties (via events)
 Consequences (deterministic or stochastic)
91
Decision Tree Nodes Time
 Decision (choice) Node
 Chance (event) Node
 Terminal (consequence) node

 Outcome (cost or benefit)
92
Decision Tree for a civil engineering project
93
Folding Back a Decision Tree
 For identifying the best decision in the tree

 Work from right to left
 Calculate the expected payoff at each outcome
node
 Choose the best alternative at each decision
node (based on expected payoff)
94
Decision Trees for Multistage
Decision-Making Problems
 Multistage problems involve a sequence of
several decisions and outcomes
 It is possible for a decision to be immediately
followed by another decision
 Decision trees are best for showing the
sequential arrangement
95
(Not
included
for the
Final
Exam)
96
Risk Preference
 People are not indifferent to uncertainty
 Lack of indifference from uncertainty arises from
uneven preferences for different outcomes
 E.g. someone may
 dislike losing $x far more than gaining $x
 value gaining $x far more than they disvalue losing $x.
 Individuals differ in comfort with uncertainty
based on circumstances and preferences
 Risk averse individuals will pay “risk premiums”
to avoid uncertainty
97
Risk preference
 The preference depends on decision maker point of
view
98
Categories of Risk Attitudes
 Risk attitude is a general way of classifying risk
preferences
 Classifications
 Risk averse fear loss and seek sureness
 Risk neutral are indifferent to uncertainty
 Risk lovers hope to win big and don t mind losing as
much
 Risk attitudes change over
 Time
 Circumstance
99
Decision Making Under Risk
 Expected Return (ER)*

 Select the alternative with the highest (long term)
expected return
 A weighted average of the possible returns for
each alternative, with the probabilities used as
weights
* Also referred to as Expected Value (EV) or Expected
Monetary Value (EMV)
**Note that this amount will not be obtained in the short
term, or if the decision is a one-time event!
100
Decision Criteria
 Expected Monetary Value (EMV)

 The expected profit for taking action Aj
 Expected Opportunity Loss (EOL)
 The expected opportunity loss for taking action
Aj
 Expected Value of Perfect Information
(EVPI)
 The expected opportunity loss from the best
decision
101
Decision Making Under Risk
 Where probabilities of outcomes are available
 Expected Monetary Value (EMV) uses the

probabilities to calculate the average payoff for
each alternative
EMV (for alternative i) =

å(probability of outcome) x (payoff of outcome)
102
Expected Monetary Value
Goal: Maximize expected value

 The expected monetary value is the weighted
average payoff, given specified probabilities for
each event N
EMV ( j )   X ij Pi
i 1
Where EMV(j) = expected monetary value of action j

Xij = payoff for action j when event i occurs
Pi = probability of event i
103
Expected Monetary Value (EMV) Method
Outcomes (Demand)
Alternatives High Moderate Low EMV
Large plant 200,000 100,000 -120,000 86,000
Small plant 90,000 50,000 -20,000 48,000
No plant 0 0 0 0
Probability
0.3 0.5 0.2
of outcome
Chose the large plant

104
Expected Opportunity Loss (EOL)
 How much regret do we expect based on the
probabilities?
EOL (for alternative i) =

å(probability of outcome) x (regret of outcome)
105
Expected Opportunity Loss
Goal: Minimize expected opportunity loss
 The expected opportunity loss is the weighted

average loss, given specified probabilities for
each event
N
EOL(j)   L ijPi
i 1
Where EOL(j) = expected monetary value of action j

Lij = opportunity loss for action j when event i occurs
Pi = probability of event i
106
Regret (Opportunity Loss) Values
Outcomes (Demand)
Alternatives High Moderate Low EOL
Large plant 0 0 120,000 24,000
Small plant 110,000 50,000 20,000 62,000
No plant 200,000 100,000 0 110,000
Probability
0.3 0.5 0.2
of outcome
Chose the large plant

107
Perfect Information
 Perfect Information would tell us with certainty which outcome is going
to occur
 Having perfect information before making a decision would allow
choosing the best payoff for the outcome
 Expected Value With Perfect Information (EVwPI)
The expected payoff of having perfect information before making a
decision
EVwPI = å (probability of outcome) × ( best payoff of outcome)
 Expected Value of Perfect Information (EVPI)
 The amount by which perfect information would increase our expected
payoff
 Provides an upper bound on what to pay for additional information
EVPI = EVwPI – EMV
EVwPI = Expected value with perfect information
EMV = the best EMV without perfect information
108
Payoffs in blue would be chosen based on
perfect information (knowing demand level)
Demand
Alternatives High Moderate Low
Large plant 200,000 100,000 -120,000
Small plant 90,000 50,000 -20,000
No plant 0 0 0
Probability 0.3 0.5 0.2
EVwPI = $110,000
109
Expected Value of Perfect
Information
EVPI = EVwPI – EMV

= $110,000 - $86,000 = $24,000
 The “perfect information” increases the

expected value by $24,000
 Would it be worth $30,000 to obtain this perfect
information for demand?
110
Using Excel to Calculate EVPI: Formulas View
Construction
A B C D E
1
2
3 Payoffs States of Nature Expected Return
4 Alternatives Low (50 units) Medium (100 units) High (150 units) ER
5 Build 50 400000 400000 400000 =SUMPRODUCT(B5:D5,B$8:D$8)
6 Build 100 100000 800000 800000 =SUMPRODUCT(B6:D6,B$8:D$8)
7 Build 150 -200000 500000 1200000 =SUMPRODUCT(B7:D7,B$8:D$8)
8 Probability 0.2 0.5 0.3
9 Best Decision =MAX(B5:B7) =MAX(C5:C7) =MAX(D5:D7)
10
11 EVwPI = =SUMPRODUCT(B9:D9,B8:D8)
12 EVBest = =MAX(E5:E7)
13 EVPI = =E11-E12
14
111
Expected Value of
Sample Information (EVSI)
 The Thompson Lumber survey provides sample

information (not perfect information)
 What is the value of this sample information?
EVSI = (EMV with free sample information)

- (EMV w/o any information)
If sample information had been free
EMV (with free SI) = 87,961 + 4000 =
$91,961
EVSI = 91,961 – 86,000 = $5,961
112
Decision Making
with Sample Information
Prior
Probability
 Permits revising old
probabilities based on New
new information Information
Revised
Probability
113
Utility
 Utility is the pleasure or satisfaction obtained
from an action.
 The utility of an outcome may not be the same
for each individual.
 Utility Examples
Each incremental $1 of profit does not have the same value to
every individual:
A risk averse person, once reaching a goal, assigns less utility to
each incremental $1.
A risk seeker assigns more utility to each incremental $1.
A risk neutral person assigns the same utility to each extra $1.
114
Three Types of Utility Curves
$ $ $
Risk Averter Risk Seeker Risk-Neutral
115
Maximizing Expected Utility
 Making decisions in terms of utility, not $
 Translate $ outcomes into utility outcomes

 Calculate expected utilities for each action
 Choose the action to maximize expected utility
116
The Utility Theory
 When individuals are faced with uncertainty they
make choices as is they are maximizing a given
criterion: the expected utility.
 Expected utility is a measure of the individual's
implicit preference, for each policy in the risk
environment.
 It is represented by a numerical value associated
with each monetary gain or loss in order to
indicate the utility of these monetary values to
the decision-maker.
117
Adding a Preference function
1.35
1
.7
125 100 65
Expected (mean) value
E = (0.5)(125) + (0.25)(95) + (0.25)(65) = -102.5
Utility value:
f(E) = å Pa * f(a) = 0.5 f(125) + 0.25 f(95) + .25 f(65) =
= .5*0.7 + .25*1.05 + .25*1.35 = ~0.95
Certainty value = -102.5*0.975 = -97.38 118
Utility Theory
 An alternative to EMV
 People view risk and money differently, so EMV
is not always the best criterion
 Utility theory incorporates a person’s attitude
toward risk
 A utility function converts a person’s attitude
toward money and risk into a number between 0
and 1
119
Civil contractor’s Utility Assessment
Contractor is asked: What is the minimum amount

that would cause you to choose alternative 2?
120
 Suppose contractor says $15,000
 contractor would rather have the certainty of
getting $15,000 rather the possibility of getting
$50,000
 Utility calculation:
U($15,000) = U($0) x 0.5 + U($50,000) x 0.5
Where, U($0) = U(worst payoff) = 0
U($50,000) = U(best payoff) = 1
U($15,000) = 0 x 0.5 + 1 x 0.5 = 0.5 (for contractor)
121
 The same gamble is presented to contractor s
multiple times with various values for the two
payoffs
 Each time Jane chooses her minimum certainty

equivalent and her utility value is calculated
 A utility curve plots these values
122
Contractor’s Utility Curve
123
 Different people will have different curves
 Contractor’s curve is typical of a risk avoider
 Risk premium is the EMV a person is willing to
willing to give up to avoid the risk
Risk premium = (EMV of gamble)

– (Certainty equivalent)
Jane’s risk premium = $25,000 - $15,000

= $10,000
124
Utility Curves for Different Risk
Preferences
125
Utility as a
Decision Making Criterion
 Construct the decision tree as usual with the

same alternative, outcomes, and probabilities
 Utility values replace monetary values
 Fold back as usual calculating expected utility
values
126
Decision Tree Example for another Contractor
127
Utility Curve for Contractor as
Risk Seeker
128
Contractor’s Decision Tree With Utility Values
129
Acknowledgment
 Statistics for Business and Economics, 6th
Edition. (2007) Pearson Education, Inc
 Statistics for Managers Using Microsoft Excel,
5th Edition. (2008) Prentice-Hall, Inc.
130

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Notes for STAT-402

For CS and IT students mainly

Sets, Operations on sets, Venn Diagram

After completing this section, one should be able to:

Fundamental Counting Principle can be used

Fundamental Counting Principle states that

For a college interview, Ali/Alia has to

A Permutation is an arrangement of items in a

A combination lock will open when the right

A Combination is an arrangement of items in

Practice: A basketball team consists of two centers, five forwards,

Thus, the number of ways to select the

 A and B are Mutually Exclusive S

 Events E1, E2, … Ek are Collectively Exhaustive

Let A be the event “Number rolled is even”

Complements: A  {1, 3, 5} B  {1, 2, 3}

Intersections: A  B  {4, 6} A  B  {5}

(the notation means that the summation is over all

3. Probability of sample space is 1 P(S)  1 0 Impossible

 the limit of the proportion of times that an event A occurs in a large

 The Addition rule:

 The Multiplication rule (When events are independent):

Probabilities and joint probabilities for two events A

A P(A  B) P(A  B ) P(A)

A P(A  B) P(A  B ) P(A)

P(B) P( B ) P(S)  1.0

= 26/52 + 4/52 - 2/52 = 28/52

P(A  B) The conditional

P(A  B) The conditional

 Of the cars on a used car lot, 70% have air

 What is the probability that a car has a CD

i.e., we want to find P(CD | AC)

P(A | B)  P(A) if P(B)>0

P(B | A)  P(B) if P(A)>0

P(AC Ç CD) = 0.2 ¹ P(AC)P(CD) = 0.28

 Defined basic probability concepts

After completing this section, one should be able to:

 Use Poisson discrete probability distributions to find

 Roll a die twice

 Toss a coin 5 times.

 P(x)  0 for any value of x

 The individual probabilities sum to 1;

(The notation indicates summation over all possible x values)

compute expected value of x: 2 .25

E(x) = (0 x .25) + (1 x .50) + (2 x .25)

 Example: Toss 2 coins, X = # heads,

Possible number of heads

Hypergeometric Gaussian or Normal

 A manufacturing plant labels items as either

 nP  (5)(0.5)  2.5 P(x) n = 5 P = 0.5

Optional check boxe

P(x = 3 | n = 10, P = .35) = .2522

P(x > 5 | n = 10, P = .35) = .0949

 Apply the Poi on Di tribution when:

 The hape of the Poi on Di tribution

P(x)   P(x, y) P(y)   P(x, y)

 Similarly, the conditional probability function of X, given

 A set of k random variables are independent if and only

 The expected value of (X - X)(Y - Y) is called the

 The covariance measures the strength of the

 If two random variables are statistically

 = 0  no linear relationship between X and Y

 The mean value for W is

W  E[W]  E[aX  bY]